Examining the Termination of the Proposed AbbVie and Shire Mega-Merger
The decision by AbbVie Inc. and Shire to terminate their proposed $54.7-billion merger raises questions on the role of tax policy on merger and acquisition activity and corporate investment.
The proposed nearly $55-billion merger of Shire and AbbVie seemed to be going smoothly until a notice issued by the US Department of Treasury in late September addressed the issue of corporate tax inversion. Corporate tax inversion is when a US-based multinational company restructures so that the US parent is replaced by a foreign corporation as a means to achieve a lower tax rate. Without the financial benefit of an inversion structure to achieve tax relief, AbbVie decided to terminate the deal. The AbbVie/Shire deal was the second mega-merger in the pharmaceutical industry this year with a tax inversion structure; the proposed $119 billion mega-merger of Pfizer and AstraZeneca deal was the first. DCAT Value Chain Insights examines the implications of tax policy on merger and acquisition activity and corporate investment.
The decision to end the deal
AbbVie Inc. and Shire agreed to terminate their proposed $54.7-billion merger following the decision by AbbVie’s board to withdraw support for the proposed transaction. The company’s decision was based upon its assessment of the September 22, 2014 notice issued by the US Department of Treasury concerning corporate tax inversions, whereby a US-based multinational company restructures so that the US parent is replaced by a foreign corporation as a means to achieve a lower tax rate. With the decision not to proceed with the deal, Shire is entitled to a $1.6-billion break-up fee from AbbVie.
AbbVie’s proposed acquisition proposal of Shire involved a tax inversion structure by which the New AbbVie was to become a holding company for the combined AbbVie and Shire and which was to be incorporated in Jersey, the UK, Shire’s current place of incorporation. Through its incorporation in the UK, the AbbVie board expected the transaction to reduce New AbbVie’s effective tax rate to approximately 13% by 2016. In a statement, AbbVie said that the notice introduced an “unacceptable level of risk and uncertainty given the magnitude of the proposed changes and the stated intention of the Department of Treasury to continue to revise tax principles to further impact such transactions.”
Assessing the implications
The US Department of Treasury’s decision to address corporate tax inversions was based not only on the proposed AbbVie/Shire acquisition, but also other high-profile proposed mergers, most notably Pfizer’s $119-billion proposal to acquire AstraZeneca. Although that deal did not move forward due to a lack of interest by AstraZeneca, it was noteworthy that Pfizer cited the financial benefits of corporate inversion to achieve tax benefits as one rationale for the proposed merger. Pfizer’s pursuit of AstraZeneca ended on May 26, 2014, when Pfizer announced it would not make a formal bid to acquire AstraZeneca, a move it had to make in line with UK takeover rules that required the company to either make a formal offer to AstraZeneca or announce that it was not making an offer following Pfizer’s non-binding $119-billion proposal to combine the two companies. Under that proposal, the two companies would have been incorporated under a new UK-incorporated holding company with management and operations maintained in both the US and the UK.
In response to these deals and others, the US Department of Treasury issued a notice in late September 2014 to limit corporate tax inversions. In a statement in announcing its notice, US Department of Treasury Secretary Jacob Lew said: “Treasury is announcing targeted action to meaningfully reduce the economic benefits of corporate inversions, and when possible, stop them altogether. This action will significantly diminish the ability of inverted companies to escape US taxation. For some companies considering deals, today’s action will mean that inversions no longer make economic sense. These are transactions in which a US-based multinational restructures so that the US parent establishes a foreign tax domicile, in large part to avoid US taxes. This shifting of a firm’s tax address is not the same as a merger driven by business reasons, such as efficiency or expansion. These transactions may be legal, but they are wrong, and our laws should change.”
In its notice, the Treasury Department outlined how its provisions would apply. An inverted company is subject to potential adverse tax consequences if, after the transaction: (1) less than 25% of the new multinational entity’s business activity is in the home country of the new foreign parent, and (2) the shareholders of the old US parent end up owning at least 60% of the shares of the new foreign parent. If these criteria are met for an inverted company, the tax consequences depend on the continuing ownership stake of the shareholders from the former US parent. If the continuing ownership stake is 80% or more, the new foreign parent is treated as a US corporation (despite the new corporate address), thereby nullifying the inversion for tax purposes. If the continuing ownership stake is at least 60% but less than 80%, US tax law respects the foreign status of the new foreign parent but other potentially adverse tax consequences may follow. In outlining those requirements, the Treasury Department sought to address the current wave of inversions involving ownership ranges of 60% to 80%.
The US Department of Treasury’s actions
The US Treasury Department Notice eliminated certain techniques inverted companies currently use to access the overseas earnings of foreign subsidiaries of the US company that inverts without paying US tax. “This notice is an important initial step in addressing inversions,” said the notice. “Treasury will continue to examine ways to reduce the tax benefits of inversions, including through additional regulatory guidance as well as by reviewing our tax treaties and other international commitments. Today’s [issued September 22, 2014] Notice requests comments on additional ways that Treasury can make inversion deals less economically appealing.”
Specifically, the US Treasury Department notice specified it will prevent inverted companies from accessing a foreign subsidiary’s earnings while deferring US tax through the use of creative loans, which are known as “hopscotch” loans. Under current law, US multinationals owe US tax on the profits of their controlled foreign corporations (CFCs) although they don’t usually have to pay this tax until those profits are repatriated (that is, paid to the US parent firm as a dividend), according to the notice. Profits that have not yet been repatriated are known as deferred earnings. Under current law, if a CFC, tries to avoid this dividend tax by investing in certain US propertyâ€”such as by making a loan to, or investing in stock of its US parent or one of its domestic affiliatesâ€”the US parent is treated as if it received a taxable dividend from the CFC. However, some inverted companies get around this rule by having the CFC make the loan to the new foreign parent, instead of its US parent. This “hopscotch” loan is not currently considered US property and is therefore not taxed as a dividend. The notice removes benefits of these “hopscotch” loans by providing that such loans are considered “US property” for purposes of applying the anti-avoidance rule. The same dividend rules will now apply as if the CFC had made a loan to the US parent prior to the inversion.
The notice also prevents inverted companies from restructuring a foreign subsidiary in order to access the subsidiary’s earnings tax-free. After an inversion, some US multinationals avoid ever paying US tax on the deferred earnings of their CFC by having the new foreign parent buy enough stock to take control of the CFC away from the former US parent. This “de-controlling” strategy is used to allow the new foreign parent to access the deferred earnings of the CFC without ever paying US tax on them. Under the notice, the new foreign parent would be treated as owning stock in the former US parent, rather than the CFC, to remove the benefits of the “de-controlling” strategy. The CFC would remain a CFC and would continue to be subject to US tax on its profits and deferred earnings.
The notice also closes a loophole to prevent inverted companies from transferring cash or property from a CFC to the new parent to completely avoid US tax. These transactions involve the new foreign parent selling its stock in the former US parent to a CFC with deferred earnings in exchange for cash or property of the CFC, effectively resulting in a tax-free repatriation of cash or property bypassing the US parent. The notice eliminates the ability to use this strategy.
The US Treasury Department’s notice also makes it more difficult for US entities to invert by strengthening the requirement that the former owners of the US entity own less than 80% of the new combined entity. It limits the ability of companies to count passive assets that are not part of the entity’s daily business functions in order to inflate the new foreign parent’s size and therefore evade the 80% rule, known as using a “cash box. Companies can successfully invert when the US entity has, for example, a value of 79% and the foreign “acquirer” has a value of 21% of the combined entity. However, in some inversion transactions, the foreign acquirer’s size is inflated by passive assets, also known as “cash boxes,” such as cash or marketable securities. These assets are not used by the entity for daily business functions. The notice would disregard stock of the foreign parent that is attributable to passive assets in the context of this 80% requirement. This would apply if at least 50% of the foreign corporation’s assets are passive. Banks and other financial services companies would be exempted.
The notice also prevents US companies from reducing their size pre-inversion by making extraordinary dividends. In some instancesa US entity may pay out large dividends pre-inversion to reduce its size and meet the 80%, also known as “skinny-down” dividends, according to the notice. The notice specified that these pre-inversion extraordinary dividends for purposes of the ownership requirement would be disregarded, thereby raising the US entity’s ownership, possibly above the 80% threshold.
The notice also prevents a US entity from inverting a portion of its operations by transferring assets to a newly formed foreign corporation that it spins off to its shareholders, thereby avoiding the associated US tax liabilities, a practice known as “spinversion” In some cases, a US entity may invert a portion of its operations by transferring a portion of its assets to a newly formed foreign corporation and then spinning-off that corporation to its public shareholders. This transaction takes advantage of a rule that was intended to permit purely internal restructurings by multinationals. Under the notice, the spun-off foreign corporation would not benefit from these internal restructuring rules with the result that the spun off company would be treated as a domestic corporation, eliminating the use of this technique for these transactions.
Commenting on the transaction termination, AbbVie’s Chairman and Chief Executive Officer, Richard A. Gonzalez addressed the larger issue of US corporate tax policy. “The unprecedented unilateral action by the US Department of Treasury may have destroyed the value in this transaction, but it does not resolve a critical issue facing American businesses today. The US tax code is outdated and is putting global US-based companies at a disadvantage to foreign competitors in an area of critical importance, specifically investing in the United States. Comprehensive tax reform is essential to create competitiveness and to stimulate investment in the economy.”